1031 Tax Deferred Exchange Transactions

A 1031 tax deferred exchange, also known as a Starker Exchange or like-kind exchange, is a transaction that allows a real estate investor to defer the capital gains tax on the sale of appreciated property IF they reinvest the proceeds in another like-kind property.

A traditional 1031 exchange involves the simultaneous swap of your property for another property. However, in 1979 a decision by the U.S. Court of Appeals in the Starker case paved the way for what is known today as a Starker exchange. The Starker exchange allows you to sell your property first and the buy your replacement property at a later date. This is by far the most common form of 1031 exchanges done today.

Tax deferred exchanges can provide incredible opportunities for real estate investors. But beware... as their popularity has grown so has the amount of mis-information. While the exchange may sound simple in premise, there are very specific rules that must be followed in a 1031 tax deferred exchange to completely defer the capital gains tax.

Failure to follow the rules closely will jeopardize your exchange

I  have extensive experience guiding investors through the ins and outs of like-kind, 1031 tax deferred exchanges. As you read the rules below, you will understand the importance of having a real estate broker who has a high degree of expertise in 1031 exchanges working for you.

Here is a list of critical rules that must be followed to successfully complete a 1031 tax deferred exchange:

You must not have any access to the money from the sale of your property.

While using a Qualified Intermediary is not mandatory to complete a deferred exchange, it is strongly recommended. Without one, you have to meet one of the IRS' complicated safe harbor requirements to successfully complete your exchange.

You must reinvest all of the proceeds from the sale of your property into the new property. If you do not, you will have to recognize a capital gain based on the amount of money not reinvested.

Once you sell your existing property, you have 45 days to identify a replacement property. You may identify more than one replacement property, but if you do, you must comply with one of the following three rules:

1. 3-Property Rule: You may identify up to three replacement properties without regard to their value; OR
2. 200% Rule: You may identify as many properties as you want as long as the total value of all the properties does not exceed twice the value of the property you are relinquishing; OR
3. 95% Rule: You may identify as many properties as you want but the property (or properties) you eventually buy must have a value equal to at least 95% of all the properties you identified. For example, if you identify five properties worth $1 million collectively, the property you end up buying must have a value of at least $950,000.

Once you sell your existing property, you must close on your new property within the earlier of 180 days or the due date of your tax return (including extensions). It is important to remember that the 45 day identification period runs concurrently with the 180 day closing period.

The replacement property must be of equal or greater value to the property you are relinquishing. You must trade up in value or you will end up recognizing a capital gain for the decrease in value between your old property and new property.

The property exchanged must be either held for investment or used in a trade or business. Your personal residence does not qualify for 1031 exchange treatment unless it was used in your business. However, under section 121 of the Internal Revenue Code, you can exclude up to $250,000 (if single) or $500,000 (if married) of the gain on the sale of your personal residence if certain requirements are met.

The property exchanged must be like-kind property. The IRS is very liberal in defining like-kind property of real estate. Almost any type of real estate, improved or unimproved, can be exchanged for other real estate. The following types of properties are considered like-kind for 1031 exchange purposes:

•  A residential rental property and a commercial rental property
• A shopping mall and an undeveloped piece of land
• A condominium and a share of a cooperative
• Permanent conservation easements in two different pieces of real estate
• Water rights of unlimited duration and farmland

A 1031 exchange is a tax-deferred exchange, not a tax-free exchange. If you complete a 1031 exchange, you can defer the capital gains taxes on the sale of your existing property. However, if you later sell the replacement property, you will have to pay capital gains taxes (if you in fact have a capital gain). You may, of course, do another 1031 exchange with your replacement property and keep deferring your capital gains tax. The way to actually avoid the capital gains tax is to hold your replacement property until you die. Then, your heirs will inherit your property at fair market value and can sell it with no (or very little) capital gains taxes due.

I am always happy to talk with real estate investors about 1031 tax deferred exchanges. Please feel free to call me at 707-535-8807 or email me now.

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